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Will China's Inflation Problem Cool in 2011?

Last year proved to be yet another strong economic period for China. Within the Pan-Asian region, China's spending spree in the last couple of years has directly benefited its neighboring economies, as the rest of the developed world continue to work slowly through the most painful global recession on record. China's insatiable appetite for the world's natural resources to fuel its export-driven economic engine was again the focal reason for the country's strong year — a trend that's carrying through into 2011. China's almost routine double-digit GDP growth has long been the subject of much concern and debate among various global central bankers, leading economists and even local government officials in mainland China and Hong Kong. The painful result of aggressive economic growth traditionally has been inflation, along with all of its economic warts, which is what China is now facing.

Curbing the negative effects of inflation is the focal job of a country's central bank. China's central bank, the People's Bank of China (PBoC), executed several fiscal and monetary policy moves in 2010, as it attempted to gradually slow their economy to a more manageable level, but not kill off growth altogether. From a high level, these actions appear to be finally taking hold. A recent key economic report issued by the government, the Purchasing Manager Index (PMI), which surveys China's industrial sector, weakened aggressively in the fourth quarter of 2010. Last month's PMI actually showed a reading of 52.2, which was the weakest performance since August 2010, but still confirmed the economy is growing via its above-50 reading.

Despite the PBoC's efforts last year, raising local lending rates, lowering government-controlled loan quotas, and raising reserve requirement ratios several times, inflation risks continue to be the most immediate concern for the government. China's stated goal of a 4 percent inflation target rate is expected to be exceeded by nearly 1 percent in February, as a growing number of China's 1.3 billion people are feeling the immediate pain of higher costs, specifically in food and energy, sparking very public anger. Unlike its Western counterparts, China's Communist Party is acutely obsessed with social stability. The fear of losing control, as experienced by Middle East regimes so far this year, is its clear and present concern.

Because of China's closed structure and its highly regulated financial system, the PBoC's financial toolbox is limited at best, and traditionally has depended on a somewhat stable global economy to be effective. The most public monetary tool has been the political "hot potato" of currency appreciation. China's enormously successful export machine in the last twenty years has been driven primarily by being the "low cost" producer via its undervalued currency (the renminbi or RMB). Many believe the undervalued RMB helped fuel the West's "low inflation" spending spree that led up the financial crisis of 2008. The currency mantra from global leaders in the West has been to urge China to aggressively appreciate the RMB as a way to protect their local economies, and this has grown louder as the recovery drags on, but China has so far resisted. While aggressive appreciation would quiet its critics in the short-term, it could have a severely negative effect on China's local economy, specifically its exporters, forcing them to further reduce margins to stay competitive, and eventually risk job growth and elevate unemployment. Despite those risks, the PBoC has stepped up its managed-float currency appreciation program. While it's been seen as an improvement over its more muted stair-step appreciation approach of the last decade, the RMB is still viewed as severely undervalued. The RMB is widely expected to appreciate 5-7 percent in 2011, but despite that projection the global outcry continues to call for steeper gains. 2010 saw the RMB appreciate approximately 4 percent, but Chinas still amassed a huge trade surplus, with exports exceeded imports by nearly $183 billion — again illustrating to the world that it enjoys an unfair advantage in world trade. The undervalued RMB has other negative effects as well.

China's nearly $2.8 trillion of currency reserves it amassed via multi-year trade surpluses is the most striking side effect of this unique state/capitalism economic model. It continues to build ever-growing piles of U.S. debt to maintain its overly competitive exchange rate. But while China's master plan is deemed successful for now, the policy points to three distinct negatives: it inflates the money supply, creates international trade tensions, and prolongs its long addiction to exports.

As mentioned before, rebalancing its domestic economy would be an easier prospect if the world economy were on stronger footing. The recent financial crisis prompted China to open its fiscal floodgates, starting in 2008 with its RMB 4 trillion ($609 billion) stimulus plan, and fast forwarding to 2010, where aggressive bank lending exceeded the planned RMB 7.5 trillion ceiling, worrying China's skeptics about how things will play out when the proverbial music stops. As economic theory goes, quality of growth matters as much as the pace, but is China now setting itself up for a bad-loan crisis (primarily in real estate) that was needed to sustain its aggressive expansion plans? We could see this play out later this year as the recovery of Western economies gains steam and global investors look elsewhere for value and return.

Among the many challenges China is faced with and must now juggle: controlled/slower growth, surging oil and food costs, hot money finding its way into the Mainland from the West, a widening gap between the rich and poor, and global demands for greater openness. All could prove to be the ultimate test for this maturing superpower as it tries to find its place at the adult's economic dinner table.

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the author and do not reflect the views of SVB Financial Group, or Silicon
Valley Bank, or any of its affiliates. This material, including without
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Last year proved to be yet another strong economic period for China. Within the Pan-Asian region, China's spending spree in the last couple of years has directly benefited its neighboring economies, as the rest of the developed world continue to work slowly through the most painful global recession on record. China's insatiable appetite for the world's natural resources to fuel its export-driven economic engine was again the focal reason for the country's strong year — a trend that's carrying through into 2011. China's almost routine double-digit GDP growth has long been the subject of much concern and debate among various global central bankers, leading economists and even local government officials in mainland China and Hong Kong. The painful result of aggressive economic growth traditionally has been inflation, along with all of its economic warts, which is what China is now facing.

Curbing the negative effects of inflation is the focal job of a country's central bank. China's central bank, the People's Bank of China (PBoC), executed several fiscal and monetary policy moves in 2010, as it attempted to gradually slow their economy to a more manageable level, but not kill off growth altogether. From a high level, these actions appear to be finally taking hold. A recent key economic report issued by the government, the Purchasing Manager Index (PMI), which surveys China's industrial sector, weakened aggressively in the fourth quarter of 2010. Last month's PMI actually showed a reading of 52.2, which was the weakest performance since August 2010, but still confirmed the economy is growing via its above-50 reading.

Despite the PBoC's efforts last year, raising local lending rates, lowering government-controlled loan quotas, and raising reserve requirement ratios several times, inflation risks continue to be the most immediate concern for the government. China's stated goal of a 4 percent inflation target rate is expected to be exceeded by nearly 1 percent in February, as a growing number of China's 1.3 billion people are feeling the immediate pain of higher costs, specifically in food and energy, sparking very public anger. Unlike its Western...Read More

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